Impax blog

Droughts, water utilities and regulators

4 Jul 2016 - by Sid Jha

The long term investment thesis for water utilities requires confidence in the regulatory framework.

Regulators need to navigate a delicate balance between authorising sufficiently attractive rates of return to attract private sector capital to finance new water infrastructure projects, while maintaining equitable access to a basic human need.  Regulation in the water sector has generally been successful and has delivered value for money and attracted investment for several decades, although water pricing can be politically challenging in many countries. 

A deep understanding of regulation, and the ability to anticipate regulatory responses, forms a major part of an investor’s due diligence on water utility investment opportunities.  This diligence is especially important during periods of crisis such as droughts or other extreme weather events.

How the utilities have fared in two drought stricken regions

Both California and the Sao Paolo region in Brazil have suffered severe droughts in recent years. The snow packs in the Sierra Nevada Mountains, which provide 30% of California’s water supplies, hit their lowest level in 500 years in the summer of 2015 [1].   Meanwhile, Sao Paolo’s Cantareira reservoir levels dropped to as low as 10% of capacity in 2014-15, but are thankfully now appearing to be normalising.  Share prices for many of the water utilities serving these regions initially underperformed broader market indices as investors were disappointed by drought-related surprises to both revenues and costs. 

A constructive approach from regulators

Much of the initial share price underperformance for water utilities in drought affected regions has subsequently been recovered and is due, in no small part, to supportive regulatory action.

Investors need to have the confidence to look through periods of underperformance, which may become more frequent as the incidence of extreme weather events appears to be increasing around the world, and are seeking assurance from regulators.  In the case of Brazil and California, this regulatory support appears to exist and we expect that water utilities will be permitted to recover drought related expenditures, while also increasing their capital expenditure on projects that will improve the future security of water supply.

The Brazilian water regulator ARSESP recognises the need for substantial investment in the region’s water system and has been supportive of water utility investment plans.  In total, including an extraordinary rate rise, ARSESP approved a 15% tariff increase in 2015, followed by an 8.5% increase in 2016 versus an average 5.6% increase over the prior 10 year period.  A greater proportion of capital expenditure is now committed to securing the future water supply in a direct response to the structural weaknesses that the drought exposed in the region’s infrastructure. 

In California, one water utility is planning an additional $550 million of utility plant expenditure.  This is approximately 27% higher over the next three years relative to its activity over the past three years.  The primary justification for this hike is the need to invest in improving the resilience of the water infrastructure.  Aside from conventional initiatives to upgrade water mains and replace ageing pipes to reduce systemic water losses, new projects such as brackish water desalination schemes and enhanced waste water recycling are being proposed to increase the security of water supply.  The California Public Utilities Commission is due to opine on rate case applications in early 2017, and we look forward to assessing the result.

Focus on all three value drivers

For water utilities, growth is based on ongoing high levels of investment, to meet demand and improve resource efficiency.  Regulation generally supports this, typically leading to the generation of higher receipts and supports earnings growth.

As equity investors, our focus remains on the key drivers of value for water utilities: price, volume and costs. 

While we remain cautious on the outlook for the latter we believe that the market often underappreciates the potential growth in earnings derived from ongoing and enhanced levels of capital investment that benefit from regulatory support.

[1] Nature, 2015

 

 

 

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